Allowing Yuan to Float- Only Real Inflation Solution for China

The Wall Street Journal reported that the CPI in China jumped 5.6% for the month of July. Food prices are mostly to blame with meat products rising 45%. China’s Central Bank has been attempting to head-off inflationary pressures by raising short-term rates for the forth time this year. On August 22nd, the one-year rate banks pay on deposits increased 27bps to 3.60%. The one-year benchmark lending rate was lifted 18bps to 7.02%.

The People’s Bank of China wants to encourage its citizens to park more of their money in deposit savings accounts which has been a tough sell due to negative real deposit rates (stated interest - inflation). Inflation fears prompt citizens to increase present spending because postponement leads to a loss of purchase power.

Raising rates will not curb China’s inflation problem. China’s currency is way too undervalued and that is the primary force driving up consumer prices. A cheap Yuan makes Chinese goods cheap relative to the rest of the world. Cash has been pouring into China’s economy due to the huge demand for their inexpensive goods. That increases China’s money supply, thus fuels inflation. If the Chinese government would let their currency float, then natural economic forces would resolve the problem. Demand for Chinese goods means demand for their currency which would cause the Yuan to appreciate and subsequently slow the demand for their exports. Yet, the currency is fixed at an artificial exchange rate thus hoards of trade dollars continue to flow into China with no end in sight.

With respect to food inflation, the problem is that China has 1.3 billion people and that’s good number of mouths to feed. Throughout China’s existence, it has been a self-sufficient society isolated from the rest of the world. China produced most all the food it needed with in its borders. Ever since China opened up for trade, its GDP has been soaring. The primary driver is from the movement of production from inefficient goods to areas where they have a comparative advantage. Farming isn’t one of them. To feed the whole population requires farming land that is arid with very low yields. On the margin, it may take 20 acres and 10x the labor to produce the same amount of rice that 1 acre in Arkansas could. The solution is to move those resources and labor into competitive export industries, such as manufacturing. They money made from manufacturing exports can be used to import rice.

The wide-scale shift to urban centers and manufacturing by default expands China’s GDP. China’s economy was inefficient since capital and labor were deployed in areas that offered very low returns. Hence, the Chinese were engaged in activities they were very poor at, not focusing on what they did best. Allocating factors of production to their most efficient use automatically boosts domestic output. Export good that can be sold higher abroad than domestically, and import goods that are less expensive across the border.

A key issue to making this all work is a floating exchange rate. When China’s population left the fields for the factories, agricultural production capacity shrank. A larger proportion of China’s food supply has to be imported to offset reduced domestic production. China’s problem is the high cost of imports. The actual goods aren’t more expensive per se, it’s the high cost of foreign currency needed to purchase them. That’s the flip side to the coin. China’s undervalued currency allows the flooding of its exports to foreign markets, yet importing is costly.

The goal of the Chinese government is to build their economy by exporting; an undervalued currency accomplishes that goal as well as protecting domestic markets from imports. Demand for food is inelastic, meaning that price increases do not lead to lower quantities demanded. If the movie ticket prices go up, people will see fewer movies, but if the price of food increases, consumers are forced to absorb the higher cost.

Attacking inflation by tightening the money supply won’t address the whole problem. The only real, long-term solution to Chinese price stability is to allow the currency to float.